Thank you for your letter dateci 25 October, in which you seek clarifications concerning ltaly's 2017 Draft Budgetary Pian (DBP) .

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Rome, 27 October 2016

Thank you for your letter dateci 25 October, in which you seek clarifications concerning ltaly's 2017 Draft Budgetary Pian (DBP) .

In particular, you are enquiring about the revision of ltaly's fiscal targets with respect to the commitments made last spring.

The macroeconomie outlook has worsened since last spring due to external factors, including increased geopolitica! risks, which have caused a slowdown in European growth and a lowering of projected global tracie growth. ltaly's officiai real GDP growth forecasts for 2016 and 2017 in the DBP have been reduced as a re sult. The output gap is now projected at -1.7 percent of potential output, down from a previous estimate of -1.1 percent in the Stability Program.

Furthermore, inflation remains at ultra-low levels that complicate the effort of reducing the debt- to-GDP ratio ¹ . AII this implies that the ltalian economy is sti li experiencing difficult cyclical conditions and thus suggests a more graduai adjustment towards the Medium Term Objective, which remains a balanced structural budget in 2019.

On the subject of the output gap, I note that so me progress is being made at the technical level on the estimation of member states' potenti al output. However, the ltalian government believes that further enhancements of the 'agreed methodology' are necessary to achieve output gap estimates that are consistent with macroeconomie evidence (such as core inflation and wage growth differentials among member states) and to minimise th e risi< of pro-cyclical fiscal policies.

There is urgent need to address concerns regarding the uncertainty of output gap estimates and the con sistency of relateci policy guidance. lf we ba sed the analysis of ltaly's fiscal policy on alternative potential growth estimates, which also imply a slower closure of the output gap in coming years, ltaly's fiscal strategy for 2017 would appear in quite a different light ² .

1 This argument was analysed in depth in the Report on R elevant F actors lnfluenci ng ltaly's Debt that we sent to the Commission in M ay of this year.

2 ltaly's 2016 Stability Program shows highly promising r esults obtained by replacing the CUBS indicator of capacity

uti lization in the production f unct ion model with an alternative indicator of labour hoarding. CUBS is used to

estimate the cycl ical component of Total Factor Productivity.

Given that your letter also mentions our commitments in terms of public investment and structural reforms, I also take the opportunity to confirm that the Government is implementing a coherent pian of investment and structural reforms in arder to boost the growth potential of the economy and to steer the expectations of economie agents towards sustained GDP growth.

On investment, further legislative measures have been adopted in 2016 to support public works and to streamline authorisation procedures while reinforcing anti-corruption policies.

Some measures have been specifically designed to accelerate the implementation of programs co-financed by the European Union. The 2017 Budget envisages a steady increase in public investment during the 2017-2019 period, reinforcing the turnaround effected in 2015-2016.

The commitment made with respect to the investment clause is a government priority and its fulfillment is the object of specific monitoring to address bottlenecks and ensure a swift and smooth execution of co-financed public investment. In addition, significant fiscal resources in the 2017 Budget are devoted to supporting private investment, innovation, and productivity. These policy areas are aligned with the Country Specific Recommendations to ltaly.

As for structural reforms, attention is currently focused on the upcoming referendum on the Constitutional reform, the impact of which on the economy can be significant. Meanwhile, however, work to fulfil our reform commitments has continued apace, notably in the domain of the labour market, public administration, governance of the banking system and insolvency procedures. Moreover, Parliament is currently reading important reforms tabled by the government, such as the Competition Law and the reform of the penai code and the statute of limitations ^3• A major reform of the tax administration aimed at improving collection procedures, streamlining administration and merging the tax collection agency with the revenue agency is also included in the Budget Law for 2017.

Returning to the subject of the structural balance, besides cyclical considerations, the change in the 2017 target compared to the 2016 Stability Program is largely explained by extraordinary expenditures relating to immigration and seismic risks.

For immigration, we foresee additional extraordinary expenditures in excess of 0.2 percent of GDP in 2017. The number of immigrants and refugees landing on our shores or rescued by our navy and coast guard has soared this year, and there are concrete risks that this trend will persist in 2017. As of 26 October, 156,705 individuals have been rescued so far this year, more than in the whole of 2015.

The number of migrants arriving in ltaly in 2016 is more than three times the leve! in 2013 and even higher than 2011-2012, the period following the 'Arab Spring' (see Figure 1 in the Annex). Furthermore, ltaly's effort started earlier than for other EU countries, as it has been

3

The DBP reviews recent reform initiatives and updates the reform timetable in light of the 2016 Country Specific

facing unprecedented pressure since 2014 due to the conflict and the lax border controls in Libya.

The intensity of the flows and the large number of women and minors involved raises the humanitarian severity of the crisis.

External borders should be a matter of common responsibility. ltaly is playing a criticai role in securing Europe's external borders and has made an exceptional financial effort on behalf of the European Union to fulfil its humanitarian obligations. Since the outbreak of the emergency, dose to half a million people were saved at sea. At its October meeting, the European Council acknowledged the emergency in tackling migratory flows and notably the prevention of illegal immigration along the Centrai Mediterranean route. The Council also recognized "the significant contribution, including of financial nature, made by frontline member states in recent years."

To this aim, immigration expenditure should not be evaluated only in terms of year-on- year changes, but relative to the situation ltaly would experience if it were not the EU external border. Expenses for rescue operations, first provision of health care assistance, shelter and education for the more than 20,000 unaccompanied minors are estimateci at €3.3 billion euro (net of EU contributions) in 2016 and €3.8 billion (0.22 percent of GDP) in 2017 in a steady-state scenario. Should the influx continue to grow at the recent pace, the expenditure would rise to

€4.2 billion (0.24 percent of GDP), as shown in the DBP. lt should be underlined that, unlike other member states, ltaly's estimates do not include the additional cost of socia! integration for migrants, as they are not directly relateci to the management of the 'European border.' As a result, let me stress that these estimates are very low compared to what has been put forward by other member states, most recently in their Draft Budgetary Plans.

Most of the costs incurred are relateci to rescue at sea, identification, shelter, clothes and food. On an accounting basis, they transiate into higher personnel costs, operating costs and amortization of ships and aircraft. In the appendix to this letter, we present a quantification of these expenditures by EAS and functional categories for the steady-state scenario (table 1 and 2), gross and net of the EU share of the External Borders Fund, the Return Fund, Refugee Fund and lntegration Fund for non-EU country nationals.

I would also like to recali that ltaly is mostly viewed by migrants as a transit country, which reduces the medium to long-term economie benefit resulting from the enlargement of the labor force.

Moreover, given the difficulties in implementing the EU relocation plans foreseen by the

Justice and Internal Affairs Council last year, ltaly has been forced to take further measures to

relieve the pressure on provinces and municipalities where the presence of migrants is highly

concentrateci. To this purpose, the law decree approved by the Council of Ministers on 21

October introduces a new national 'reception pian' based on relocating migrants and refugees

among ltalian municipalities based on proportionality and sustainability criteria.

As concerns seismic risks, the government in 2017 will incur considerable expenses for earthquake ass istance and reconstruction totaling €2.8 billion. Furthermore, given the frequency of destructive earthquakes and the suffering they have caused the ltalian population, the government intends to carry out an additional program addressing seismic risks more forcefully and promptly than has been the case in the past. This action is necessary to secure for instance our 42 thousand schoo l buildings, 30 per cent of which are either in need of structural maintenance or must be completely rebuilt.

We thus decided to earmark a relevant share of the additional public investment in the 2017 Budget to anti-seismic infrastructure, schools and public offices. In addition, tax incentives for anti-seismic investment are increased, targeting private dwellings. The budgetary cost in 2017 of anti-seismic incentives is estimateci at €2 billion. Taken together, increased public investment and anti-se ismic tax incentives entail budgetary costs of dose to 0.2 percent of GDP.

We remain at the Commission's disposal should you wish to discuss any of the above points in greater detail.

Yours sincerely,

Mr. Valdis Dombrovskis Vice President

European Commission Brussels

Mr. Pierre Moscovici

Economy and Finance Minister

Commissioner, Economie and Financial Affairs European Commission

Brusse ls

Annex

FIGURE 1: ARRIVALS

OF MIGRANTS ON ITALY'S COASTS (1991-2016)

. '

180.000 160.000 140.000 120.000 100.000 80.000 60.000 40.000 20.000

Source: Port authorities and Ministry of Internal affairs.

180.000

•2013 02014

160.000

140.000

120.000

100.000

80.000

60.000

40.000

20.000

Annual 1 ° quarter

Source: Ministry of Internal affairs.

02015

2°quarter

02016

(up to 26th October)

3 °quarter 4 •quarter

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2011 2012 2013 2014 2015 2016 2017

1. Compensalion of employees (D.1) 97,1 82,7 81,0 84,3 88,1 89,1 88,9

2. lntermediate consumption (P.2) 190,0 198,6 218.0 346,8 429,6 349.1 388,0

3. Social payments (D.62, D.63) 149,1 160,2 306.0 636,6 1.172,3 1.720,9 2.215,2

4. Subsidies (D.3)

5. Gross fixed capitai formation (P .51) 39,5 62,7 288,7 340,1 253,7 423.0 391,5

6. Capitai transfers (D.9) ^.

7. Other 446,5 394,4 462,1 797,0 791,7 848,4 830,6

8. Total lmpact on headllne deficit 922,1 898,6 1.355,8 2.204,7 2.735,6 3.430,6 3.914,1 (8) = r(1..7)

9. Compensalion from EU 94,3 65,2 100,7 160,2 120,2 112,1 87,0

10. Total impact on headllne defic it net of

EU contrlbutions 827,8 833,5 1.255,0 2.044,5 2.615,4 3.318,5 3.827 ,1

(10) = (8) • (9)

11. Total lmpact on headllne deficit net of EU

con trlbulions 0,05 0,05 0,08 0,13 0,16 0,20 0,22

(% GDP)

Note: The data do not include the expenditure relateci to the so-called "Arab Spring emergency", initiated during 2011 and officially ended on 1 January 2 013. Approximations made when unit costs were not available by ESA category. More specifically, the ongoing costs of Defense are considered entirely as intermediate consumption and education, health, contributions to Turkey (excluded from the EU budget) and EU funds and national co-financing relateci are classified as other expenditures.

Source: State Generai Accounting D epartment

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2011 2012 20 13 2014 2 015 2016 2017

1. lnilial reception costs* 244,6 269,7 479,0 683,5 1.304,1 1.883,7 2.364,0

2. Transport (includlng rescue operatlons) 347.4 280,5 525,6 982,7 837,5 881,7 860.8

3. Health-care 74,6 86,5 137,7 207,8 243,7 250,0 250,0

4. Admlnlstralive costs (incl. processlng 44,2 43,2 38,5 43,7 40,3 38,5 30,4

applications for asylum)

5. Contrlbutions to Turkey Facility (excluding o.o o.o o.o o. o o.o ^{66,6 98,9}

through EU Budget)

6. Other costs and measures**

educatlon 211,2 218,7 174,9 287,1 310,0 310,0 310,0

7. Total l mpact on headline defi cit 922,1 898,6 1.355,8 2.204,7 2.735,6 3.430,6 3.914,1 (7)

r(1..6)

Note: The data do not include t he expenditure relateci to the so-called "Arab Spring emergency", initiated during 2011 and offici ally ended on 1 January 2013 .

Source: State generai Accounting Department